Carlisle Tobias E. Deep Value: Why Activist Investors and Other Contrarians Battle For Control of Losing Corporations

Wiley, 2014. — 243 p.Deep value is investment triumph disguised as business disaster. It is a simple, but counterintuitive idea: Under the right conditions, losing stocks — those in crisis, with apparently failing businesses, and uncertain futures — offer unusually favorable investment prospects. This is a philosophy that runs counter to the received wisdom of the market. Many investors believe that a good business and a good investment are the same thing. Many value investors, inspired by Warren Buffett’s example, believe that a good, undervalued business is the best investment. The research seems to offer a contradictory view. Though they appear intensely unappealing — perhaps because they appear so intensely unappealing — deeply undervalued companies offer very attractive returns. Often found in calamity, they have tanking market prices, receding earnings, and the equity looks like poison. At the extreme, they might be losing money and headed for liquidation. That’s why they’re cheap. As Benjamin Graham noted in Security Analysis, “If the profits had been increasing steadily it is obvious that the shares would not sell at so low a price. The objection to buying these issues lies in the probability, or at least the possibility, that earnings will decline or losses continue, and that the resources will be dissipated and the intrinsic value ultimately become less than the price paid.” This book is an investigation of the evidence, and the conditions under which losing stocks become asymmetric opportunities, with limited downside and enormous upside.At its heart, deep value investing is simply the methodical application of timeless principles proven by over 80 years of research and practice. The intellectual basis for it is Graham’s Security Analysis, the foundational document for the school of investing now known as value investing. Through his genius and his experience, Graham understood intuitively what other researchers would demonstrate empirically over the eight decades since his book was first published: That stocks appear most attractive on a fundamental basis at the peak of their business cycle when they represent the worst risk-reward ratio, and least attractive at the bottom of the cycle when the opportunity is at its best. This has several implications for investors. First, the research, which we discuss in the book, shows that the magnitude of market price discount to intrinsic value — the margin of safety in value investing parlance — is more important than the rate of growth in earnings, or the return on invested capital, a measure of business quality. This seems contradictory to Buffett’s exhortation to favor “wonderful companies at fair prices”—which generate sustainable, high returns on capital — over “fair companies at wonderful prices”—those that are cheap, but do not possess any economic advantage.In the book, we examine why Buffett, who was Graham’s most apt student, sometime employee, long-time friend, and intellectual heir, evolved his investment style away from Graham’s under the influence of his friend and business partner, Charlie Munger. We examine why Munger prompted Buffett to seek out the wonderful company, one that could compound growth while throwing off cash to shareholders. We analyze the textbook example of such a business to understand what makes it “wonderful,” and then test the theory to see whether buying stocks that meet Buffett’s criteria leads to consistent, market-beating performance over the long term. Do Buffett’s wonderful companies outperform without Buffett’s genius for qualitative business analysis, and, if so, what is the real cause? We know that a wonderful company will earn an average return if the market price reflects its fair value. To outperform, the price must be discounted — the wider the discount, or margin of safety, the better the return — or the business must be more wonderful than the market believes. Wonderful company investors must therefore determine both whether a superior business can sustain its unusual profitability, and the extent to which the stock price already anticipates its ability to do so. This is a difficult undertaking because, as we’ll see, it is the rare company that does so. And we don’t well understand what allows it to do so. In most cases competition works on high quality businesses to push their returns back to average, and some even become loss makers. What appears to be an unusually strong business tends to be one enjoying unusually favorable conditions, right at the pinnacle of its business cycle.